Over the years, the North Carolina General Assembly has enacted various tax credits designed to promote investment in the state, including credits for renewable energy projects and historic rehabilitation. By all accounts, the legislation has succeeded, resulting in significant additional tax revenue and the creation of new jobs, often in the most economically distressed areas of North Carolina. Recognizing their importance to the state’s economy, a bill that would expand the historic rehabilitation tax credit was recently introduced. “Historic tax credits . . . contribute to our economy by creating jobs while preserving the historic identities of our communities,” the sponsor of the legislation told the Raleigh News & Observer. The Historic Tax Credits Act of 2019 would increase the amount of credit currently available and provide an additional credit for areas of the state affected by natural disasters.
At the same time the general assembly is considering an expansion of tax credits, the North Carolina Department of Revenue has embarked on an audit program aimed directly at businesses and individuals who have invested in solar projects and historic rehabilitation in the state. The department is disallowing millions of dollars of tax credits under a new and extremely restrictive interpretation that is taking investors, developers, and the market by surprise. The department’s audit initiative appears at odds with both the intent of the General Assembly and a recent North Carolina Supreme Court decision regarding the role of the Internal Revenue Code in state tax matters.
The Department’s Interpretation of Partnership Tax Credits
In September 2018, the department published an “Important Notice: Tax Credits Involving Partnerships.” In that notice, the department states that federal tax concepts control the requirements for North Carolina tax credits. According to the department, when determining eligibility for a state tax credit, the federal disguised sale and bona fide partner rules apply. The department has been disallowing state tax credits based on its interpretation and application of those rules. Specifically, the department contends a disguised sale determination prevents the allocation of the tax credit under state law. Similarly, the department asserts that a person who is not a “bona fide partner” under federal income tax law would not qualify for allocation of a credit.
The notice states: “North Carolina generally follows the Code, subject to statutory exceptions and definitional differences.” The department references the North Carolina Supreme Court’s 2017 decision in Fidelity Bank for this assertion. The notice further states that several federal cases:
have addressed federal income tax issues that are relevant for North Carolina tax credits claimed by partnerships and taxpayers. Notably, Virginia Historic Tax Credit provides an analysis of disguised sale transactions involving tax credits, and Historic Boardwalk discusses bona fide partner and partnership arrangements. Because Virginia Historic Tax Credit is a Fourth Circuit Court of Appeals decision, the case is controlling for North Carolina.
The department’s position in the notice is flawed for a number of reasons (including that decisions of the Fourth Circuit Court of Appeals are not controlling in North Carolina state courts). Most significantly, it is contrary to the state Supreme Court’s decision in Fidelity and the department’s stated interpretation in that case.
Implicit Importation of Federal Law Is Contrary to ‘Fidelity’
Although there are other problems with the department’s interpretation and application of federal law, the underlying premise of the notice is fundamentally flawed. The statement that North Carolina generally follows the Internal Revenue Code unless the general assembly specifically decouples is precisely the opposite of the rule announced by the North Carolina Supreme Court in Fidelity. This assertion also directly contradicts the position the department advocated in that case.
Under the North Carolina Constitution, the power of taxation “shall never be surrendered, suspended, or contracted away.” In light of this constitutional limitation, the North Carolina Attorney General has advised the department that a “statute which adopts by reference future amendments to the Internal Revenue Code would . . . be invalidated by as an unconstitutional delegation of legislative power.” Thus, under the North Carolina Constitution, any adoption of federal tax rules must be affirmatively enacted by the general assembly.
North Carolina adopts the Internal Revenue Code for several purposes, including as the starting point for the calculation of North Carolina income tax. This does not mean, however, that all of the provisions of the code are imported into the Revenue Act. The North Carolina Supreme Court recently recognized this fundamental point in the Fidelity case: “As a general proposition, when the General Assembly intends to adopt provisions or definitions from other sources of law into a statute, it does so by clear and specific reference.” As the court explained:
A careful review of the provisions of Chapter 105 of the General Statutes demonstrates . . . that the General Assembly has not adopted the definitions set out in the Internal Revenue Code into the North Carolina Revenue Act on any sort of wholesale basis. Instead, the General Assembly has selectively incorporated certain of the definitions contained in the Internal Revenue Code into the North Carolina Revenue Act. . . . In the event that the provisions of the Internal Revenue Code were binding throughout the North Carolina Revenue Act, these references to the Code in other portions of [the tax statute] would be superfluous.
Furthermore, contrary to its position in the notice, the department told the court in Fidelity that the revenue act did not universally adopt the code for all purposes but included only those federal provisions specifically adopted by the general assembly. In fact, the department explained that—even though federal taxable income serves as the starting point for North Carolina taxable income—the revenue act was not “a wholesale adoption of all Code provisions and definitions.”
The requirements for the renewable energy and historic rehabilitation tax credits are specifically delineated in the North Carolina statutes. Those statutes also contain the circumstances that cause a credit to expire or terminate. Because the North Carolina General Assembly has not adopted either the federal disguised sale or bona fide partner rules, the department is improperly importing (and applying) them to disallow state tax credits. This fundamental error is contrary to the letter and spirit of the law, not to mention the North Carolina Constitution.
Kay Hobart, partner with Parker Poe, has more than 20 years of experience in state tax controversy matters and tax litigation at all levels of state and federal court. She has litigated numerous high profile, complex multimillion-dollar cases before the North Carolina Business Court, Court of Appeals, and Supreme Court. Kay can be reached at firstname.lastname@example.org.